The Safety-first, Goals-based Approach to Financial Planning

Little of what is taught in traditional investment textbooks is of value in personal financial planning. Risk is not standard deviation; it is the probability and consequences of not meeting one’s goals.  That real-world perspective animates a new book by Zvi Bodie and Rachelle Taqqu that implores advisors and their clients to lock in the funding of their essential expenses before worrying about their discretionary goals.

Bodie’s and Taqqu’s Risk Less and Prosper: Your Guide to Safer Investing, helps bring the safety-first, goals-based investment portfolio approach to the forefront of financial planning, especially when it comes to preparing for retirement. The idea from which the book proceeds is to focus on retirement spending goals and to decide what is essential and what is discretionary. Essential spending needs should be locked in by funding them with safe investments – the sort that cannot possibly fail to achieve clearly defined goals – while more discretionary and aspirational retirement expenditures are funded with volatile assets that allow for a chance that risks manifest and goals are not met. By considering both future income and future expenses, those looking ahead to retirement can develop a strategy to meet their goals while taking as little risk as possible.

What’s new, and what’s not

For clients to whom the guiding principles of a safety-first, flooring approach to retirement planning are brand-new, Bodie’s and Taqqu’s book provides an effective introduction. Though in some ways client-centric, however, for advisors the book helpfully synthesizes several different approaches that can help to build an advisor’s retirement planning toolkit. Advisors looking for a more detailed manual spelling out the flooring approach, however, may be better served by Michael J. Zwecher’s Retirement Portfolios: Theory, Construction, and Management. Bodie and Taqqu focus more on the intuition of flooring.

They also specifically emphasize the use of inflation-protected bonds (TIPS and I Bonds) to create inflation-adjusted flooring. The focus on TIPS follows from Bodie’s and Michael J. Clowes’ 2003 book, Worry-Free Investing: A Safe Approach to Achieving Your Lifetime Financial Goals, but the newer book expands beyond TIPS to also consider single-premium immediate annuities, a means of protecting against longevity risk past the bond ladder’s terminal date.

Bodie and Taqqu also describe a lifetime approach to broader financial planning, adopting some features found in Dan Nevin’s Goals-based Investing: Integrating Traditional and Behavioral Finance from the spring 2004 Journal of Wealth Management. These features include allowing for mental accounting so that different goals (retirement vs. children’s education, for instance), are funded with separate portfolios, as well as the emphasis on distinguishing needs from wants. The broader message is also shared with goals-based investing: The objective is not to maximize returns or to beat a benchmark, but rather to find investments that will help to reach financial goals with as little risk as possible.

Bodie and Taqqu also emphasize the inclusion of human capital in the lifetime balance sheet. Lifetime assets, including both financial assets and potential future earnings, must balance lifetime liabilities (retirement spending, spending on other goals, pre-retirement spending). More risk can be taken both when the time horizon is longer (because this provides more opportunities to adapt and save) and when income is more flexible (because this provides opportunities to work more should investment risk manifest).